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When Leasehold Improvements Offer Tax Savings Opportunities

With the current state of the economy, real estate owners and developers are faced with many major issues as current tenants are going out of business and the pool of new tenants is shallow. Although these issues are unfortunate, they also provide opportunities for tax savings.

When a tenant leaves, a landlord is left with the question, “what can be done with the finished space that the tenant left behind?” Since the introduction of the Modified Accelerated Cost Recovery System (MACRS), the IRS has not allowed the owner of a building to write off an original structural component of that building when that portion has been replaced. For example, when a roof of a building was replaced, the IRS would require that the new roof be capitalized and depreciated, but not allow the write off of the adjusted basis of the old roof which was no longer there. This would cause a situation where the owner of the building was depreciating two or more components of the building (in this example, two roofs) when only one component was in place.

Congress realized this problem and addressed it in the Small Business Job Protection Act of 1996. Under this Act, Congress believed that costs specifically related to the leasing of property which would not provide a future benefit beyond the lease and, as a result, should not be recovered beyond the term of that lease. To put it simply, real estate owners can now write-off certain improvements they paid for pursuant to a lease when those improvements are abandoned by the tenant. Structural components such as doors, drywall, and ceiling tiles which are depreciated over 39 years are able to be written off when abandoned in certain cases.

In the previous paragraph, the key question a landlord has to answer is “what costs, which did not provide any other future benefit to the space, were abandoned?” For the purpose of applying this provision, a lessor must be able to separately account for the adjusted basis of the leasehold improvements that are abandoned. A guess or estimate of the cost or portion of the total cost which represent the abandoned improvements will not be allowed by the IRS. Rarely is a total tenant improvement abandoned. In many cases, part of the tenant improvement is basic electrical and HVAC duct work which are improvements that will remain in place for future tenants and therefore not be truly abandoned. These costs, of course, would not be eligible to be written off.

The other key to pay attention to is that the costs of the improvement for the prior tenant have to be disposed of completely, meaning that those items have to be demolished or removed for the next tenant. For example, if an entrance door is put in on a certain side of the building for the current tenant and remains there for the next tenant, that cost was not disposed of and will provide future benefit. With these facts, the cost of the entrance would not be eligible to be written off when abandoned by the original tenant. If the entrance was moved to another side and for the new tenant, though, that original entrance would have been disposed of making the initial cost eligible.

If you have purchased the building and are faced with abandoned spaces, there are a couple questions that you must ask yourself. First, was the building purchased with the intention to demolish the current empty spaces? If this is the case, no abandonment losses can be taken because the owner did not intend to rent those spaces out and, according to the rule, abandonment losses can only be taken on space the owner is intending to rent. If you have purchased a building, intended to rent out the spaces, and qualify for abandonment losses, a cost segregation study is something that should be in place to support the costs that were written off. If the building is purchased, a cost segregation study is not only the best way, but truly the only way, to determine what costs are being abandoned and should be written off.

One other question is, “what if I have not written off abandonments that that occurred in prior tax years?” Fortunately, starting with 2008 tax returns, the IRS will allow you to write off these previous abandonments in the current year as an Automatic Consent to a Change in Accounting Method.

Note: There are certain tax savings opportunities for the renovations of old tenant space and for attracting new tenants. This blog focused on tax savings for space vacated by current tenants.